How will the changes to the accredited investor definition impact startup fundraising?

This post originally appeared on Ryan's blog, Unproductive.

I want to cover some of the recent changes to the "accredited investor" definition and how this may impact startup fundraising. I have been following this change for the past several months and think it is important for startup founders to understand the broader context of these regulatory changes. This stuff gets very technical since it deals with securities regulations, but I will do my best to summarize these changes as simply as I can. I will also provide lots of links to other materials to make it easy for anyone looking for a deeper dive. 

Background

On August 26, 2020 the Securities and Exchange Commission (SEC) announced changes to the accredited investor definition which will become effective on October 25, 2020. The initial proposal was introduced in December of last year. This change is the first in response to an SEC initiative begun in July of 2019 considering updates to the regulatory framework for how private companies can raise money. 

The "accredited investor" definition is a part of the rules and regulations governing federal securities offerings, specifically Regulation D which controls private placement exemptions to securities registration. It is particularly relevant to startups because an overwhelming majority of startup fundraising is done through what is called a 506(b) transaction. This is a specific way to structure a deal so it will have a securities compliance safe harbor (presumed to comply if the specific rules are followed). 

506(b) allows a company to raise any amount of money so long as the investors are all accredited or from no more than 35 unaccredited investors. Any unaccredited investors in this offering must also have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of investing in the startup. The regulations further stipulate that these types of unaccredited investors must be provided a certain level of informational disclosures---accredited investors do not need to receive these disclosures. Additionally, startups relying on 506(b) cannot generally solicit or advertise their offering. Most startups relying on 506(b) for their registration exemption do not involve unaccredited investors because the additional informational requirements are often too expensive to produce relative to the amount of money unaccredited investors plan to invest.  

So then, it is really important for startups to structure their funding round to make sure all their investors fall within the accredited investor definition. Currently, the primary way that early-stage investors qualify as accredited investors is to be a natural person (skin and bones) and have a net worth over $1M (including their spouse but excluding the value of their primary residence) and/or over $200K in income in each of the previous two years ($300K including their spouse) with a reasonable expectation that they will have the same income in the current year. There are also certain types of entities that can qualify as accredited investors if they have more than $5M dollars in assets. Finally, executive officers and directors of the startup can also qualify as accredited investors. 

Overview of the Updates

When the SEC initially took public comments last year on ways it could update the private company fundraising regulations, the largest area of public commentary was on updating the accredited investor definition. Many of the SEC updates were directly in response to what was advocated within the original comments. Here is a summary of the updates.

A natural person can now be accredited by holding certain professional certifications

By far the most novel of the changes to the accredited investor definition is that now a natural person (skin and bones) can be accredited if they hold an active certification from an accrediting body approved by the SEC. The SEC laid out the criteria that the accrediting organizations have to meet to have their members qualify under this subsection in the updated rules. Initially, the only certifications that will qualify will be holding a FINRA Series 7, Series 65, or Series 82 license. 

Knowledgeable employees of private funds

Under the new rules, if a natural person (again, skin and bones) is deemed a "knowledgeable employee" under Rule 3c-5(a)(4) of the Investment Act, that person can be an accredited investor but will be accredited only for purposes of investing in the fund for which they are employed. This is a pretty specific new aspect of the rules but one that will allow certain types of employees of VC and related funds to be able to invest in their employers and get some upside opportunity. 

Refreshed the list of entities with $5M in assets that can qualify

When the accredited investor definition was first created, LLCs did not even exist. The SEC specifically clarified that LLCs can qualify as accredited investors along with registered investment advisors, exempt reporting advisers, and rural business investment companies. 

Adding a catchall for other types of entities not specifically designated

The SEC also added a catchall provision to allow any entity not specifically formed for the purpose of investing in the specific offered security and with investments (emphasized for distinction) over $5M to qualify as accredited investors. This catchall was made in response to several tribal governments, state funds, and foreign formed entities pointing out their inability to participate under the old definition. 

Allowing family offices to become accredited investors

"Family offices" and their "family clients" as defined within the Investment Advisers Act with at least $5M in assets under management can become accredited investors. This group was added in response to the growing number of family offices that have been interested in making investments in private companies over the past few decades. 

Adding "spousal equivalents" to the accredited investor definition

Soon "spousal equivalents" will be able to pool their wealth together in order to qualify as accredited investors. A spousal equivalent is "a cohabitant occupying a relationship generally equivalent to that of a spouse." This new rule allows people who may have partners but not necessarily legal spouses to be afforded the same privileges as legally recognized spouses. This distinction was already incorporated into the crowdfunding regulations and made sense to harmonize with the accredited investor definition. 

How will this impact startup funding? 

I think the impacts that these changes will have on the startup funding ecosystem will be fairly minor. While there are several hundred thousand holders of Series 7, Series 65, and Series 82 licenses, there is no indication that they have an appetite to invest the typical check sizes (usually starting around $5K -- $10K per investor) in seed/angel deals. Investment diversity is still a factor for long-term success in this space, so it is unclear how many new investors that did not already qualify under the income/wealth standards will be making investments in private companies. Most of these changes are merely a modernization of the rules in response to the types of people and entities with compelling reasons to be allowed to invest in private companies. 

These changes still don't solve a big issue for early-stage startups which is getting the "friends and family" round to comply with securities regulations. These updates to the accredited investor definition don't change the rules so drastically that founders now have a painless way to take investment from their unaccredited friends and family members. These updates are unlikely to change the reality for startups that taking even relatively small amounts of money from their unaccredited friends and family comes with significant and expensive compliance burdens.

Where does it go from here?

A much more potentially impactful change proposed this past March by the SEC stands to greatly open up the fundraising options for startups. Those changes include updates to crowdfunding, how companies can structure deals, and how startups can talk about themselves and their fundraising efforts without violating general solicitation and advertising requirements---more on all this in a future post. Think of these recent changes to the accredited investor definition as the first installment of many changes that could broaden the ways in which startups can raise early-stage funding. However, the new proposed changes are sure to be met with more pushback than these most recent updates to the accredited investor definition. 

Finally, DON'T think you can comply with securities regulations just by reading this summary. This is for educational purposes only. There are tons of aspects and considerations that I left out. Every company's situation is unique and should be guided with the help of an experienced lawyer. Of all the things you can skimp on as a cost-conscious startup, securities compliance aren't one of them.